2023-07-06 03:43:59 ET
Summary
- Capital Southwest, a business development company that provides financing solutions for small to medium-sized businesses, is an attractive investment due to its high yield of over 11% and solid Q4 results.
- CSWC's strong investment portfolio, effective diversification, and consistent operating performance have earned it a BBB- rating from Fitch Ratings Inc.
- The company's current valuation also makes it an attractive investment and a great way to introduce a high-yielding stock to a portfolio.
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Introduction
Bank stocks have been a neglected sector after the meltdown of some of the largest institutions in the US. Covering in this article, we have Capital Southwest (CSWC), a business development company that hasn't seen the same level of attention as industry leaders like Main Street Capital ( MAIN ), for example.
Capital Southwest makes its revenues from providing flexible financing solutions for small to medium-sized businesses and in some cases distressed companies. It helps fill the void where larger and more well-known banks like JPMorgan ( JPM ) or Bank of America ( BAC ) aren't providing coverage.
The appealing factor with CSWC right now is the large yield it boasts, sitting above 11%. In most cases, a yield as high as this would cause most people to turn their heads, but after a solid Q4 result, an investment into CSWC looks still very appealing, resulting in a buy rating from me. What I particularly liked was the solid improvement the company saw in its fair value of investments, growing to $1.2 billion, up 29% YoY. With that, the debt-to-equity ratio also decreased to 0.88x, down from 1.16x a year prior. These improvements help reassure me that CSWC is able to perform despite tough market environments.
Company Structure
Capital Southwest focuses on filling the space that larger banks don't operate in and offers small-medium sized businesses aid with acquisitions and growth through loans. CSWC is an internally managed company, meaning they are acting to hire their own management team, which is then responsible for handling the company's assets.
This structure tends to be viewed as better, as there is more clarity regarding pay for the management team and vital information like operating expenses is widely displayed for investors' interest. The investment portfolio for the company consists primarily of First Lien Investments (86.6%), followed by equity at 9% and I-45 SLF and Second Lien Investment making up the remaining part. The portfolio consists of 85 individual companies and the avg. yield on total investments has grown to 12.1%. Worth mentioning is that the floating rate component sits at 98%, which supports growing interest income in a rising interest rate environment. In the current market, Capital Southwest is able to lend out at higher rates and I expect this to benefit the company portfolio positively, and steady growth will be visible as a result.
Where CSWC has placed a priority over the last years is maintaining a solid dividend for its investors, one which has had a 5-year growth rate of 14.33% so far, and reached a payout ratio of 89.04%. As for the FWD dividend yield, it is currently above 11%. This yield is far above the average for the financials sector, which only is 4.16% .
As for recent news, Fitch Ratings Inc recently rated CSWC with a BBB- stating stable outlooks. The reason for the rating was CSWC's strong investment portfolio which has been diversified effectively and consistent operating performance has aided in providing an above-average asset coverage cushion. I view this recent news as yet another reason for CSWC being a potential addition to a divided-focused portfolio.
Upgraded Rating
The upgraded rating from Fitch is proof that CSWC has built up a very well-managed investment portfolio that can stand the test of downturns without introducing too much risk for the company. Some of the supporting factors that resulted in the rating upgrade were CSWC's focus on "senior focus", which CSWC has in its investment portfolio. The outlook that Fitch provided was that "consistent core earnings generation" will be seen. This seems plausible, in my opinion, as the Tangible Book Value has had a 13.88% average YoY growth over the last 5 years. This highlights the quick progress that CSWC has made in just the last few years and the recent rating upgrade is recognition of this.
Fundamentals
Where people might draw the line for investment often comes down to risk. A nearing 12% yield in the case of CSWC would box it in with plenty of value traps out there. The thing with these companies is that they are just that, value traps, hiding internal issues that don't necessarily come across at first glance.
With Capital Southwest, I don't think you are buying into a value trap. Why I can draw this conclusion I think comes down to the payout ratio being very high, nearing the 90s, the debt/equity ratio as we discovered above here is 1.08, which isn't a massive discrepancy or cause for concern. Besides, it's historically trading at lower multiples right now. Fueling the dividend growth has rather than come from an increase in interest rates, actually from CSWC successfully growing its portfolio of investments. The First Lien loans remain the largest still at 83%.
Looking at the portfolio, CSWC isn't heavily weighed in one direction in terms of industry. Media & Marketing makes up together with Business Services 24% of the portfolio, at 12% equally.
Historically, CSWC has done very well in growing its operational efficiencies and now has an Opex/Average Total Assets of 1.9%, the lowest it has ever been. It's reassuring to see these improvements as the company has built up its portfolio, it translates to competent management that has made very sound investment decisions so far. As for the last quarter , the portfolio generated $0.65 of pre-tax net investment income. The company has also been successful in raising equity, $29.2 million in gross proceeds at 118% of the prevailing NAV per share for Q4. This has over the last 12 months concluded with CSWC significantly decreasing its regulatory leverage from 1.16x to 0.88x. This should play out as CSWC can maintain a solid operating performance for the remainder of the year, as we await the results of rate hikes from the FED.
Valuation Profile
Over the last 3 years, the performance between CSWC and the SPY has been quite similar in terms of share price, CSWC is up 50.7% and the SPY 42%. But this doesn't take into account the dividends that Capital Southwest has also distributed during that period, which makes it widely outperform the SPY.
Operational momentum has been key for the success of Capital Southwest, as the management structure within the business being internal has greatly helped in growing the company's portfolio. The lower operational costs of maintaining this structure have meant much of the growth has been during the last 5 years, as assets have grown 24.68% annually.
In terms of valuation, however, I am not worried about overpaying for CSWC right now. It trades below what many consider to be the best and highest quality BDC, MAIN. I think there is reason to suggest that CSWC could reach a slightly higher valuation to match MAIN. CSWC doesn't share the same amount of spotlight time that MAIN does, but the only BDC that MAIN co-operates with someone else is with CSWC. The l-45 SLF is a partnership that started in 2015. The success that MAIN has, I think, will be visible in future performances of CSWC, as the partnerships highlight some of the similarities the two have in terms of portfolio management and risk-taking.
Using the GGM model, we look at the intrinsic value of a company using the projected growth of the dividend, and then determining what the potential rate of return could be, and at what price you could realize that as well. Looking at the chart above, it suggests that to receive a 12% ROI for CSWC, paying under $30 per share right now would provide that. I have applied a smaller constant dividend increase rate than the historical 14% for CSWC in the last 5 years. The main reason is I don't see a 14% YoY increase to a dividend that is sustainable in the long run. A 5% one seems more reasonable in my opinion. The calculation for the first year would be something like Target Price ($30) = D1/(12% - 5%). Meaning paying under $30 per share would achieve the required rate of return on an investment.
A "required return" of 12% might seem high, but seeing as CSWC is a high yielding stock, I find it fitting to also require a high return. If CSWC continues to increase its dividend, investors will be able to receive such a return on investment as long as they are buying under the "value per share" I have stated, which for 2023 would be $30 per share.
Peer Comparison
Below is a comparison between CSWC and two other companies operating in the part of the financial sector.
In terms of ROE, historically, the best performer has been MAIN so far and the worst is TriplePoint Venture Growth (TPVG). As far as yield between the three, TPVG has the highest at 14%. But I think the negative ROE brings into question the sustainability of the dividend and yield.
Above is a comparison of the same companies once again. I don't necessarily view CSWC as the clear winner here, instead MAIN is a very decent contender too. It's all about what type of investor you are. If you are more risk tolerant and don't mind a higher-yielding stock in your portfolio, then CSWC looks quite appealing from this. Where I see the strongest benefits is the high yield in the company with a lower valuation than the historic P/B. That together with a very good efficiency ratio makes me more prone to go with CSWC than the others. I think TPVG is the most common of these. The company carries a significant amount more debt than equity and has the highest efficiency ratios of all the companies too.
Risks
As CSWC has a portfolio with companies that are susceptible to recessions I think a fair worry about CSWC is the value of the portfolio decreasing if we enter a recession. It could result in some losses to its credit portfolio. But that is the nature of investing in BDCs. I think CSWC has proven itself to keep a portfolio that is exposed to significant risks, the non-accrual basis is just 0.3% currently. What is making a recession more likely is rising interest which puts pressure on the capital circulating. But the job market hasn't seen a harsh decline or challenge, it still remains robust and prospects of a soft landing have increased. With rising interest rates, the company in which CSWC is invested could potentially have to cut dividends, which would harm the income generated from the investment portfolio. This would result in declining ROE for CSWC, which could justify a lower valuation as more risks are associated with the company's investments.
Investor Takeaway
Where investors could have a reason for concern with CSWC or any other company in the sector is that a potential recession could lead to the disintegration of loan performances. But proof that previous challenges haven't affected CSWC is the COVID-19 pandemic example. There was no halt in the dividend, either the regular or the supplement dividend that CSWC has.
Right now, CSWC offers a solid dividend addition to a portfolio seeking a higher yield and for investors that can handle some of the risk associated with higher-yielding companies. But as has been underpinned in the article, the quality and competence of CSWC shouldn't leave anyone worried that future performance will be disappointing. I would say it will be anything but that.
For further details see:
Capital Southwest: A Sustainable Yield Attractive To Dividend Investors